Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Sunday, June 3, 2018

Self-Renting a Big Green Egg

Sometimes
tax law requires you to witness the torture of the language. Other times it herds
you through a sequence of “except for” clauses, almost assuring that some
future Court will address which except is taking exception.

And then you
have the laughers.

I came
across an article titled: Corporation’s self-leasing rental expense deduction
denied.”

I was
curious. We tax nerds have an exceptionally low threshold for curiosity.

Before
reading the article, I anticipated that:

(1)Something was being deducted

(2)That something was rent expense

(3)Something was being self-leased, whatever that
means, and

(4)Whatever it means, the deduction was denied.

Let us spend
a little time on (3).

Self-lease
(or self-rental) means that you are renting something to yourself or, more
likely, to an entity that you own. It took on greater tax significance in 1986
when Congress, frustrated for years with tax shelters, created the passive
activity (PAL) rules. The idea was to separate business activities between actually
working (active/material participation) and living the Kennedy (passive
activity).

It is not a
big deal if all the activities are profitable.

It can be a
big deal if some of the activities are unprofitable.

Let’s go
back to the classic tax shelter. A high-incomer wants to shelter high income with
a deductible tax loss.

Our high-incomer
buys a partnership interest in a horse farm or oil pipeline or Starbucks. The high-incomer
does not work at the farm/pipeline/Starbucks, of course. He or she is an investor.

In the lingo,
he/she is passive in the activity.

Contrast
that with whatever activity generates the high income. Odds are that he/she
works there. We would refer to that as active or material participation.

The 1986 tax
act greatly restricted the ability of the high-incomer to use passive losses to
offset active/material participation income.

Every now
and then, however, standard tax planning is flipped on its head. There are cases
where the high-incomer wants more passive income.

In the name
of all that is holy, why?

Has to do
with passive losses. Let’s say that you had $10,000 in passive losses in 2015.
You could not use them to offset other income, so the $10,000 carried over to
2016. Then to 2017. They are gathering dust.

If we could
create passive income, we could use those passive losses.

How to
create passive income?

Well, let’s
say that you own a company.

You rent
something to the company.

Let’s rent your
car, your office-in-home or your Big Green EGG XXL.

Rent is
passive income, right? The tax on our passive income will be zero, as the
losses will mop up every dollar of income.

That is the
“self-rental” the tax Code is after.

But it also triggers
one of those “except for” rules: if the self-rental results in income, the
income will not qualify as passive income.

All your
effort was for naught. Thank you for playing.

Back to the article
I was reading.

There is a
doctor. He is the only owner of a medical practice. He used the second story of
his house solely for the medical practice. Fair be fair, he had the practice
pay him rent for that second floor.

I have no
problem with that.

The Tax
Court disallowed the corporation a rent deduction.

Whaaat? That
makes no sense.

The purpose of
the passive/active/material participation rules is not to deny a deduction
altogether. The purpose is to delay the use of losses until the right type of
income comes around.

What was the
Tax Court thinking?

Easy. The
doctor never reported the rental income on his personal return.

This case has
nothing to do with self-rental rules. The Court simply was not permitting the corporation
a deduction for rent that its shareholder failed to report as income.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.